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Insider Trading: Playing the Devil’s Advocate

 6 min read / 

In theory, insider trading is illegal in most parts of the world. In practice, the line is often blurred, and many walk it. The largest prison sentence ever handed down for insider trading in the US was 11 years – a long way from the decades, centuries or even millennia people get for fraud.

Many believe that not only should insider trading not be illegal, but that it being widely accepted would increase the efficiency of markets. Their point: insider trading isn’t really that different to so many other business practices.

When it comes to business, there’s one word that sits at the top of everyone’s mind in relation to success: network. Those who have figured out the necessity of a network when building a career get started on it early. Parents nowadays are keen to have their children rub shoulders with the leaders of tomorrow as early as kindergarten. That way, people develop long-term relationships early on. Those people will help each other in the future: from forging business alliances to picking up the phone and informing their connections and friends about a job opening at their company. It’s called having an edge, and nobody would even think about calling this anything other than what it is: good career skills. See where their argument is headed… ?

Of course, the counter-arguments are that insider trading benefits only a few and would lead to a loss of faith in the markets with knock-on adverse economic consequences.

However, we are taught from an early age that competition builds character, and those who get that useful edge are the ones who usually get ahead. So, at the end of the day, one can ask why insider trading should be any different. If one is able to build the right network and benefit from the information provided through it, should that be considered a crime? The notion that everyone should be equal when entering the market is, in practice, impossible to achieve (and any system based on all its citizens being equal in anything other than human rights and the right to vote has been proven by history to be doomed to fail). From different training to different levels of experience and access to funds, players in the markets will never be equal – retail investors will always be at a disadvantage, in terms of access to market information, compared to institutional investors. So why should information be treated as anything else other than a useful commodity?

Could it actually spur more movement in the markets, as well as encourage others to compete in this money-making game? If everyone would try to get an edge – and succeed at one point or another – perhaps the “sum of all vices” would stay constant. The markets could even themselves out and everyone’s edge would become less prominent.

Depending on where you are in the world, the words “insider trading” can either send shivers down your spine or line your pockets while you roam carefree.

The US and the Western World

The concept of insider trading is usually frowned upon by the media, the majority of scholars, and definitely law enforcement.

There is a myriad of legislation and regulation regarding the disclosure of sensitive information. However, the question is always: what is the difference between insider and sensitive information, and where does one draw the line? Research analysts and companies alike have to make sure that they don’t push for sensitive information, or disclose it to third parties should they have it, and those providing information have to make sure they understand where the line is.

But then there’s the issue of enforcing the rules. The proverbial “counting grains of sand” certainly applies here. In the US, a case is usually investigated by the both famous and infamous SEC. Putting together information on who met whom, when, and what they did afterwards in the stock market is a gruesome job for law enforcement. And even then, in the absence of a “smoking gun”, it is all circumstantial evidence that a 12-strong jury may or may not convict on.

They say it’s all a gamble when going to court, but Martha Stewart might testify that the odds are not in one’s favour once a jury hears the case.

The Eastern Approach: China

Still, it’s not always up to a jury. This is where big data comes in. The Chinese authorities, for example, have been using it to both see irregularities in the stock market and put together incriminating movements by individuals that might have been the perpetrators of illegal activities.

That simple? Not quite.

In a very pragmatic approach, it all comes down to: cui prodest? Who benefits from the alleged crime and how much is an authority willing to spend in time, manpower and taxpayers’ money to answer that question and the many more that will arise? The vast majority of important Chinese companies are state owned, so the first question might be easy to answer and it also has a bearing on the decision whether to enforce regulation or not.

There are three paths that can be chosen for punishment: administrative, civil and criminal. The first one can, and probably will, be enforced by the China Securities Regulatory Commission, and will likely translate into a fine. The burden of proof is lighter: if X is found to have talked to Y, and Y is proved to have access to the inside information about a company, and then X makes a killing on the stock market trading shares of that company just after the talk, then the burden of proof will be on X to explain why the trading is reasonable.The authorities do not need to know the contents of the conversation and do not need to prove more than the fact that it took place. If X cannot give a logical reason, and this is very probable in the above case, X can be fined.

In a civil case, investors can sue the perpetrator for the loss.

The criminal case is where it gets more complicated. The burden of proof is very high, the equivalent of the very American “beyond a reasonable doubt”. An ironclad case would mean jail time but, as a result of the high burden needed to be met, it might prove challenging to prosecute.

So what does this mean for investors?

While the West would regard insider trading laws as well defined and understood, the East is quickly catching up and using big data and advanced algorithms to detect anomalies in trading patterns that will eventually lead to more prosecutions. We would expect this to trend to continue to raise more awareness around insider trading legislation in China and help companies that enforce best practices around this important topic to gain market share.

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